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Full text of "Tax treatment of single premium and other investment-oriented life insurance : scheduled for a hearing before the Subcommittee on Taxation and Debt Management of the Committee on Finance on March 25, 1988"

[JOINT COMMITTEE PRINT] 



TAX TREATMENT OF SINGLE PREMIUM 

AND OTHER INVESTMENT-ORIENTED 

LIFE INSURANCE 

Scheduled for a Hearing 

BEFORE THE 

SUBCOMMITTEE ON 
TAXATION AND DEBT MANAGEMENT 

OF THE 

COMMITTEE ON FINANCE 
ON MARCH 25, 1988 



Prepared by the Staff 

OF THE 

JOINT COMMITTEE ON TAXATION 




MARCH 23, 1988 



U.S. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 1988 JCS-7- 



For sale by the Superintendent of Documents, U.S. Government Printing OfRce 
Washington, DC 20402 



CONTENTS 



Page 

joduction 1 

Background and Present Law 2 

A. Background 2 

B. Present Law 5 

Analysis of Tax Benefits From Investment-Oriented 

Life Insurance Products 17 

Tax Policy Issues 23 

A. Overview 23 

B. Analysis of Specific Tax Policy Issues 25 

Proposals To Restrict the Use of Life Insurance as 

AN Investment Vehicle 31 

A. Policyholder Proposals 31 

B. Insurance Company Proposals 36 

Analysis of Proposals To Restrict the Use of Life 

Insurance as an Investment Vehicle 38 



(III) 



INTRODUCTION 

' lis pamphlet, ^ prepared by the staff of the Joint Committee on 
I ition, provides a discussion of present law, current issues, and 
( ible proposals relating to the tax treatment of single premium 
I other investment-oriented life insurance. The Subcommittee on 
) ition and Debt Management of the Senate Committee on Fi- 

I :e has scheduled a public hearing on March 25, 1988, to review 
tax provisions designed to promote life insurance to determine 

t ther such provisions are being used to encourage a particular 

I I of investment over others. In addition, the hearing will con- 
: r alternatives to the present-law tax treatment to address any 

(lems that are identified. 

irt I of the pamphlet contains a description of the various types 
ife insurance products currently being marketed; it also de- 
)es the present-law tax treatment of life insurance policies to 
:yholders and life insurance companies and provides a compari- 
of the tax treatment of other tax-favored forms of savings and 
fitment. Part II of the pamphlet contains an analysis of the tax 
jfits available from investment-oriented insurance products, fol- 
id in Part III by a discussion of the issues relating to the 
lent-law tax treatment. In Part IV of the pamphlet, various pro- 
ds (including proposals offered by several industry groups) to 
lify the tax treatment of life insurance are outlined, and Part V 
:ains a brief analysis of these proposals. 



This pamphlet may be cited as follows: Joint Committee on Taxation, Tax Treatment of 
ie Premium and Other Investment-Oriented Life Insurance (JCS-7-88), March 23, 1988. 

(1) 



I. BACKGROUND AND PRESENT LAW 
A. Background 

In general 

The traditional goal of life insurance has been to protect the p 
icyholder's beneficiaries (usually the policyholder's family) agair 
a loss of income and costs arising from the death of the pers 
whose life was insured. This goal is accomplished by pooling t 
probable cost of the same types of risk of loss over a large numfc 
of policyholders. 

In many cases, a life insurance policy will combine two e 
ments — pure insurance protection and an investment componei 
The investment component (commonly referred to as cash vah 
arises if the premiums paid by the policyholder in any year ( 
other policy term), less certain charges and plus credited earnin; 
exceeds the cost of insurance coverage provided to the policyhold 
for the year (or term). This buildup of cash value allows the pc 
ment, in later years, of premiums that are less than the curre 
cost of the insurance protection. 

An overview of the principal types of life insurance products ci 
rently being sold follows. 

Term insurance 

Term insurance is a contract that furnishes life insurance proti 
tion for a limited term. The face value of the policy is payable 
death occurs during the stipulated term of the contract. Nothing 
paid if the individual on whose life the insurance is provided si 
vives to the end of the term. Premium charges only cover the ri 
of death so little or no cash value builds up over the term of t 
policy. For any given amount of life insurance, premium charg 
increase with the policyholder's age because the risk of death (i 
the mortality charge) is age-related. As a result, term insurar 
may be impractical as a policyholder ages because the term cost 
insurance approaches a significant percentage of the face amou 
of the policy. 

Term insurance policies are most frequently issued for a peri 
of one year, although a term insurance policy may provide prot( 
tion for a shorter period (such as the duration of a plane flight) 
a longer period (such as the life expectancy of an individual), i 
though term insurance contracts are primarily protection cc 
tracts, the leveling of a premium over a long period of years p: 
duces a small cash value that increases to a point and then ( 
clines to zero at the termination of the contract. 

(2) 



'hole life insurance 

In general 
A whole life insurance contract provides for the payment of the 
ce value of the policy upon the death of the insured; payment is 
)t contingent upon death occurring within a specified period, 
ich protection may be purchased under either of two principal 

i pes of contract: (1) an ordinary life contract, or (2) a limited pay- 
ent life contract. The chief difference between the two is the 
lethod of premium payments. 

The ordinary life contract assumes that premiums will be paid 
1 a level basis throughout the insured's lifetime. In the early 

.^ars, the annual level premium is in excess of the amount re- 
hired to pay the current cost of the insurance protection (i.e., the 
irrent cost of term insurance in an amount equal to the differ- 
lace between the face amount of the policy and its cash value). The 
alance that is retained by the company, at interest, produces a 
ind which is called the cash value of the policy. This cash value 
educes the insurance element in later years when the annual level 
remium would no longer cover the annual cost of term insurance 
1 the face amount. The cash value accumulation continues until 

caching the face value of the policy at maturity (which occurs 
hen the insured reaches a specified age, typically age 95 or 100). 
Under the limited payment life contract, premiums are charged 

jr a limited number of years (such as 10 or 20 years). After the 
remium payment period, the cash value of the policy, together 

Ldth interest credited, is sufficient to pay the cost of term insur- 

I'nce protection for the remainder of the period that the policy is in 
ffect. The premium under such a contract will be significantly 
arger than the aggregate amount of premiums paid during the 
ame period under an ordinary life contract so that the company 

Pan carry the policy to maturity without further charges. 

? The insurance element in a whole life policy is the difference be- 

Pween the face amount and the cash value. The cash value that ac- 

fiumulates at interest to maturity of the contract is the investment 

l^ilement in the policy. 

i Single premium life insurance 

The most extreme form of limited payment whole life insurance 
iiis single premium life insurance. Under a single premium life in- 
surance contract, a paid-up policy is purchased at policy inception 
with a single premium payment, or a few initial payments, rather 
than a longer series of premium payments. Such a policy maxi- 
,mizes the investment element of the policy in the initial years 
lafter policy inception. In the case of single premium life insurance, 
the investment component of the initial premium is so large that 
no additional premiums need to be paid for insurance coverage. 

Universal life 
The savings or investment feature of life insurance is also char- 
acteristic of other permanent plans of life insurance, such as uni- 
versal life. Universal life insurance is a whole life insurance con- 
tract that retains the investment and insurance features of tradi- 
tional life insurance products, while disclosing the charges for in- 



surance and the interest rate credited to the policyholder. Univer 
sal life is distinguished from traditional whole life insurance prod 
ucts in that the policyholder may change the death benefit fron 
time to time (with satisfactory evidence of insurability for in 
creases) and vary the amount or timing of premium payments. Pre 
miums (less expense charges) are credited to a policy account fron 
which mortality charges are deducted and to which interest is cred 
ited at rates that may change from time to time above a minimun 
rate guaranteed in the contract. 

A universal life insurance policy generally offers the policyholde 
a basic death benefit equal to (1) a fixed face amount, or (2) th 
sum of a fixed amount plus the cash value of the policy as of th 
death of the insured. 

In a universal life policy, the investment element is the casl 
value that accumulates at interest, which interest may be adjust© 
above a minimum guaranteed rate to reflect market interest rates 
As under a traditional whole life insurance policy, the insuranc 
element of a universal life policy is the difference between the pre 
scribed death benefit and the cash value. 

Variable life 

The distinguishing feature of a variable life insurance policy i 
that the cash value of the policy effectively is invested in shares t 
a mutual fund. The cash value reflects the value of assets at tW 
time the cash value is computed. In variable life insurance policies 
the death benefit typically will vary with the value of the underlj 
ing investment account. A variable life insurance contract can h 
structured as a single premium contract or any other form (; 
whole life insurance contract. 

Premiums under variable life insurance contracts purchase unii 
in a segregated investment account managed by the insurance coni 
pany and are treated as a security subject to the Securities Act 
1933. 

Universal variable life insurance 

A universal variable contract is a type of variable life insuranc 
that features a flexible arrangement for paying premiums. In add 
tion, the policyholder may change the face amount of the polic 
and vary the amount and frequency of premium payments. Oftei 
such a policy provides that a guaranteed death benefit will be pai 
upon the death of the insured, regardless of investment earningi. 



B. Present Law 



k general 

Jnder a fundamental principle of the Federal income tax, 
lome is subject to tax when it is actually or constructively re- 
ived. Income is constructively received by a taxpayer it the 
I ome is credited to the taxpayer's account, set apart for the tax- 
, ^er or otherwise made available so that the taxpayer may draw 
nn 'it at any time or could draw upon it if notice of intent to 
-hdraw had been given. Thus, for example, interest income cred- 
i to a savings account or money market fund is taxable to the 
) ner of the account or fund when credited. , 

Special rules have been adopted under which certain income is 
^taxable at the time it normally would be taxed under general 
•ome tax principles. For example, the investment income on 
iiounts contributed (within limits) to an individual retirement ar- 
rigement (IRA) generally is not includible in income until with- 
i awn even though the taxpayer may draw upon the income at any 

Tn'the case of life insurance, a special rule also applies under 

iiich the investment income ("inside buildup ) earned on premi- 

lis credited under a contract that meets a statutory definition ot 

le insurance generally is not subject to current taxation to the 

I mer of the policy. In addition, death benefits under such a lite 

Nurance contract are excluded from the gross income of the recip- 

lit, so that neither the policyholder nor the policyholder s beneti- 

tiry is ever taxed on the inside buildup if the proceeds of the 

ilicy are paid to the policyholder's beneficiary by reason of the 

\ lath of the insured. , ^ , . 

^ Distributions from a life insurance contract that are made prior 

the death of the insured generally are not includible in income 

the extent that the amounts distributed are less than the tax- 

lyer's basis in the contract. 

Amounts borrowed under a life insurance contract generally are 
Dt treated as distributions from the contract. Consequently, the 
iside buildup attributable to amounts borrowed under a lite insur- 
ace contract is not includible in income even though the policy- 
older has current use of the inside buildup. 

Under present law, a life insurance company generally is not 
ibject to tax on the inside buildup on a life insurance or annuity 
mtract because of the reserve deduction rules applicable to lite in- 
irance companies. 
definition of life insurance 

In general 
Under present law, the favorable tax treatment accorded to life 
nsurance is only available for contracts that satisfy a definition ot 

(5) 



life insurance that was enacted as part of the Deficit Reduction Ac 
of 1984 (DEFRA). This definition was adopted to limit the permissi 
ble investment orientation of life insurance contracts to level 
more in line with traditional life insurance products. 

A life insurance contract is defined as any contract that is a lif 
insurance contract under the applicable State or foreign law, bu 
only if the contract meets either of two alternatives: (1) a cas] 
value accumulation test, or (2) a test consisting of a guideline pre 
mium requirement and a cash value corridor requirement. Which 
ever test is chosen, that test must be met for the entire life of th 
contract in order for the contract to be treated as life insurance fq 
tax purposes. In general, a contract meets the cash value accumij 
lation test if the cash surrender value may not exceed the nej 
single premium that would have to be paid to fund future benefit 
under the contract. A contract generally meets the guideline pr^ 
mium /cash value corridor test if the premiums paid under thi 
policy do not exceed certain guideline levels, and the death benefl 
under the policy is not less than a varying statutory percentage d 
the cash surrender value of the policy. 

If a contract does not satisfy the statutory definition of life insuij 
ance, the sum of (1) the increase in the cash surrender value ani 
(2) the cost of insurance coverage provided under the contract, ove! 
the premiums paid during the year (less any nontaxable distribij 
tions) is treated as ordinary income received or accrued by the poi 
icyholder during the year, and only the excess of the death benefl 
over the net surrender value of the contract is excludable from th 
income of the recipient of the death benefit. 

Cash value accumulation test 

The cash value accumulation test is intended to allow traditions 
whole life policies, with cash values that accumulate based on rea 
sonable interest rates, to qualify as life insurance contracts. i 

Under this test, the cash surrender value of the contract, by thi 
terms of the contract, may not at any time exceed the net singll 
premium which would have to be paid at such time in order t 
fund the future benefits under the contract assuming the contraC 
matures no earlier than age 95 for the insured. Thus, this te^ 
allows a recomputation of the limitation (the net single premium 
at any point in time during the contract period based on the cui 
rent and future benefits guaranteed under the contract at tha 
time. The term future benefits means death benefits and endo\^ 
ment benefits. The death benefit is the amount that is payable i 
the event of the death of the insured, without regard to any qual 
fled additional benefits. 

Cash surrender value is defined as the cash value of any contrac] 
(i.e., any amount to which the policyholder is entitled upon surrer 
der and, generally, against which the policyholder can borrow) d 
termined without regard to any surrender charge, policy loan, 
reasonable termination dividend. 

The determination of whether a contract satisfies the cash val 
accumulation test is made on the basis of the terms of the contrac 
In making this determination, the net single premium as of anj 
date is computed using a rate of interest that equals the greater c 
an annual effective rate of 4 percent or the rate or rates guararj 



»d on the issuance of the contract. The mortality charges taken 
I .'o account in computing the net single premium are those speci- 
i d in the contract, or, if none are specified in the contract, the 
I jrtality charges used in determining the statutory reserves for 

The amount of any qualified additional benefit is not taken into 
I count in determining the net single premium However the 
■ arge stated in the contract for the qualified additional benefit is 
-ated as a future benefit, thereby increasing the cash value limi- 
tion by the discounted value of that charge. Qualified additional 
nefits include guaranteed insurability, accidental death or dis- 
dlity, family term coverage, disability waiver, and any other ben- 
its prescribed under regulations. In the case of any other addi- 
)nal benefit which is not a qualified additional benefit and which 
not prefunded, neither the benefit nor the charge for such bene- 
L is taken into account. For example, if a contract provides tor 
isiness term insurance as an additional benefit, neither the term 
surance coverage nor the charge for the insurance is considered a 
ture benefit. 

J Guideline premium and cash value corridor test requirements 
In eeneral— The second alternative test under which a contract 
uay qualify as a life insurance contract has two requirenients: the 
lideline premium limitation and the cash value corridor. Ihe 
Adeline premium portion of the test distinguishes between con- 
■acts under which the policyholder makes traditional levels of in- 
Wtment through premiums and those which involve greater m- 
-stments by the policyholder. The cash value corridor disqualifies 
mtracts which allow excessive amounts of cash value to build up 
e premiums, plus income on which tax has been deferred) rela- 
ve to the life insurance risk. In combination, these requirements 
re intended to limit the definition of life insurance to contracts 
hat permit relatively modest investment and relatively modest in- 
vestment returns. . ,.^ . 4. i. ^4.^ 

' Guideline premium limitation— A life insurance contract meets 

he guideline premium limitation if the sum of the premiums paid 

inder the contract does not at any time exceed the greater of the 

:uideline single premium or the sum of the guideline level premi- 

ims to such date. The guideline single premium for any contract is 

he premium at issue required to fund future benefits under ttie 

ontract. The computation of the guideline single premium must 

ake into account (1) the mortality charges specified in the con- 

ract, or, if none are specified, the mortality charges used in deter- 

nining the statutory reserves for the contract, U) any otner 

charges specified in the contract (either for expenses or tor quali- 

led additional benefits), and (3) interest at the greater of a 6-per- 

ient annual effective rate or the rate or rates guaranteed on tne 

issuance of the contract. , , 

' The guideline level premium is the level annual amount, payable 

over a period that does not end before the insured attains age yb, 

1 which is necessary to fund future benefits under the contract. Ihe 

Pcomputation is made on the same basis as that for the guideline 

[single premium, except that the statutory interest rate is 4 percent 

[instead of 6 percent. 



8 

A premium payment that causes the sum of the premiums paid 
to exceed the guideline premium Umitation will not result in th^ 
contract failing the test if the premium payment is necessary U 
prevent termination of the contract on or before the end of the conj 
tract year, but only if the contract would terminate without caslj 
value but for such payment. Also, premiums returned to a polic}^ 
holder with interest within 60 days after the end of a contract yeai 
in order to comply with the guideline premium requirement an 
treated as a reduction of the premiums paid during the year. TH 
interest paid on such return premiums is includible in grosj 
income. 

Cash value corridor. — A life insurance contract falls within th< 
cash value corridor if the death benefit under the contract at anj 
time is equal to or greater than the applicable percentage of th< 
cash surrender value. Applicable percentages are set forth in j 
statutory table. Under the table, a life insurance contract tha 
covers an insured person who is 55 years of age at the beginning o| 
a contract year and that has a cash surrender value of $10,00(| 
must have a death benefit at that time of at least $15,000 (150 perl 
cent of $10,000). | 

As illustrated by Table 1, the applicable percentage starts at 25(1 
percent of the cash surrender value for an insured person up to 4^ 
years of age, and decreases to 100 percent when the insured persoij 
reaches age 95. Starting at age 40, there are 9 age brackets with 3 
year intervals (except for one 15-year interval) to which a specific 
applicable percentage range has been assigned. The applicable per 
centage decreases by the same amount for each year in the agt 
bracket. For example, for the 55 to 60 age bracket, the applicabh 
percentage falls from 150 to 130 percent, or 4 percentage points fo: 
each annual increase in age. At 57, the applicable percentage i 
142. 

The statutory table of applicable percentages follows: 

Table 1.— Cash Value Corridor 



In the case of an insured with an 

attained age as of the beginning of 

the contract year of — 



More than: 



But not 
more 
than: 



The applicable percentages shall 

decrease by a ratable portion for 

each full year — 



From: 



To: 



40 

40. ..1 45 

45...) 50 

50 55 

55 60 

60 65 

65 70 

70 75 

75 90 

90 95 



250 250 

250 215 

215 185 

185 150 

150 130 

130 120 

120 115 

115 105 

105 105 

105 100 



Computational rules 
■^resent law provides 4 general rules or assumptions to be ap- 
ed in computing the limitations set forth m the definitional 
Its These rules restrict the actual provisions and benefits that 
1 be offered in a life insurance contract only to the extent that 
^y restrict the allowable cash surrender value (under the cash 
lue accumulation test) or the allowable funding pattern (under 
5 3 guideline premium limitation). j ^u u i,,^ 

First, in computing the net single premium under the cash value 
cumulation test or the guideline premium limitation under any 
ntract, the death benefit generally is deemed not to increase at 
l.y time during the life of the contract (qualified additional bene- 
( s are treated in the same way). ,. r ^.u ;„ +Uo 

Second, irrespective of the maturity date actually set forth in the 
ntract, the maturity date (including the date on which any en- 
wment benefit is payable) is deemed to be no earlier than the 
ly on which the insured attains age 95 and no later than the day 
I which the insured attains age 100. ^ . • i „i^ 

Third, for purposes of applying the second computational rule 
id for purposes of determining the cash surrender value on the 
laturity date under the fourth computational rule, the death bene- 
ts are deemed to be provided until the maturity date described in 
ie second computational rule. This rule, combined with the second 
)mputational rule, will generally prevent contracts endowing at 
Ice value before age 95 from qualifying as life insurance. Howev- 
H it will allow an endowment benefit at ages before 95 for 

'mounts less than face value. . , r-^ <.u« o„«, .^f anv 

^ Fourth, the amount of any endowment benefit, or the sum ot any 
tidowment benefits, is deemed not to exceed the least amount pay- 
ble as a death benefit at any time under the contract. For these 
urposes, the term endowment benefit mcludes the cash surrender 
alue at the maturity date. 
Adjustments 
Under present law, proper adjustments must be made for any 
ihange in the future benefits or any qualified additional benefit (or 
\ny other terms) under a life insurance contract ^^A^^ Jf ^.^L"*!! 
'lected in any previous determination made under the definitional 
section. Changes in the future benefits or terms of the contract can 
)ccur by an action of the company or the policyholder or by the 

'^?Xerf isTchange in the benefits under (or in other terms of) 
:he contract that was not reflected in any previous determination 
Dr adjustment made under the definitional section, Proper adjust- 
ments must be made in future determinations ^^^er the defimtio^^ 
[f the change reduces benefits under the contract, the adjustments 
may include a required distribution in an amount that is necessary 
to enable the contract to meet the applicable definitional test. A 
portion of the cash distributed to a policyholder as a result of a 
change in future benefits is treated as being Pf^d^/^^fj. Xl^^^ 
income in the contract, rather than as a ^^^^J^^.f^^^^XS be^ 
er's investment in the contract, only if the reduction in future ben 



10 

efits occurs during the 15-year period following the issue date 
the contract. 

Contracts not meeting the life insurance definition 

If a life insurance contract does not meet either of the altern 
tive tests under the definition of a life insurance contract, tlj 
income on the contract for any taxable year of the policyholder 
treated as ordinary income received or accrued by the policyhold| 
during that year. In addition, the income on the contract for i 
prior taxable years is treated as received or accrued during the ta! 
able year in which the contract ceases to meet the definition. | 

For this purpose, the income on a contract is the amount H 
which the sum of the increase in the net surrender value of tlj 
contract during the taxable year and the cost of life insurance prj 
tection provided during the year under the contract exceed tlj 
amount of premiums paid during the taxable year less ar| 
amounts distributed under the contract during the taxable yej 
that are not includible in income. The cost of life insurance protd 
tion provided under any contract is the lesser of the cost of indivij 
ual insurance on the life of the insured as determined on the bas 
of uniform premiums, computed using 5-year age brackets, or tlj 
mortality charge stated in the contract. i 

Only the excess of the amount of death benefit paid over the n 
surrender value of the contract is treated as paid under a life ii 
surance contract for purposes of the exclusion from income of til 
beneficiary. I 

If a life insurance contract fails to meet the tests in the defiri 
tion, it nonetheless is treated as an insurance contract for oth« 
tax purposes. This insures that the premiums and income credite 
to failing policies is taken into account by the insurance compari 
in computing its taxable income. In addition, it insures that a con 
pany that issues failing policies continues to qualify as an insu 
ance company. 

Treatment of inside buildup 

The investment component of a life insurance premium is tli 
portion of the premium not used to pay the pure insurance cosi 
(including the operating, administrative, overhead charges, an 
profit of the company). This amount, which is added to the caa 
value of the policy, may be considered comparable to an interes 
bearing savings deposit. The cash value portion of the life insul 
ance policy is credited with interest annually for the life of the coi 
tract. This amount of interest is called the inside buildup, an 
under present law it is not taxed as current income^ of the policy 
holder. 

Hi. many circumstances, the investment income credited to th 
account of the policyholder is never taxed. For example, the pr( 
ceeds of the policy paid upon the death of the insured (includin 
investment income credited to the policy) are excluded from th 
beneficiary's income (sec. 101). Further, the proceeds of life insui 
ance may be excluded from the gross estate of the insured (se< 
2042). I 

Under other circumstances, a portion of the investment incom 
earned may be subject to tax. For example, if a policy is cashed i 



11 



r surrendered) in exchange for its cash surrender value, or if dis- 
ibutions are made in some other fashion, these amounts are 
xed as ordinary income to the extent that the cumulative amount 
iid exceeds the policyholder's basis (i.e., the investment in the 
intract (sees. 72(e)(5)(A) and 72(e)(6)). The investment in the con- 
lact is the difference between the total amount of premiums paid 
Ttider the contract and the amount previously received under the 
))ntract that was excludable from gross income. Under these rules, 
le portion of investment income that was used to pay for term m- 
arance protection is not subject to tax. 

Partial surrenders of a life insurance contract that are made 
rior to the death of the insured generally are not includible in 
iicome to the extent that the amounts distributed are less than the 
cixpayer's basis in the contract. 

J The investment income under a life insurance contract may be 
ubiect to tax in certain other instances. Under present law, no 
^ain or loss generally is recognized on the exchange of a contract ot 
^fe insurance for another contract of life insurance (sec WSb). 
however, any cash that a policyholder receives as a result ot an 
Exchange of policies is subject to tax to the extent that there is 
'ficome in the contract. 
borrowing under life insurance contracts 

The inside buildup on a life insurance contract generally is not 
Seated as distributed to the policyholder if the policyholder bor- 

ows under the policy even though the policyholder has current use 
k the money. Consequently, the inside buildup under a life msur- 
Ince contract generally is not taxed at the time of a bona tide poi- 

Wholder loan. ^•c^ ;„ 

^ Under present law, interest on amounts borrowed under a lite m- 
Wrance policy for personal expenditures is treated as nondeduct- 
ible personal interest (subject to a phase-in rule for taxable years 
winning in 1987 through 1990) (sec. 163(h)). Present law also 
:reats as nondeductible the interest on debt with respect to policies 
covering the life of an officer or employee of, or individual tinan- 
-ially interested in, a trade or business carried on by a taxpayer to 
'the extent the debt exceeds $50,000 per officer, employee, or indi- 
vidual (sec. 264(a)(4)). ... . „^.^« 
Policyholder loans at low or no net interest rates are not speciti- 
cally subject to the below-market loan rules under present law. 

f Comparison of tax- favored forms of investment 

I In 0eneral.-The tax treatment of cash value (whole) life insur- 
! ance contracts compares favorably with the tax treatment ot other 
Itax-favored forms of investment under present law Tax incentives 
are used to encourage retirement savings through deferred annuity 
contracts, individual retirement arrangements (IRAs), and qualitied 
pension plans (including qualified cash or deferred arrangements 
(401(k) plans) and Keogh plans (for self-employed individuals)). 

Contribution limits.-Undev present law, limits are imposed on 
contributions to qualified pension plans and IRAs, without regard 
to whether the contributions to such plans are deductible or nonde- 
ductible. On the other hand, limitations are not imposed on the 



12 

amount of premiums paid for life insurance or the amount that i 
credited to the cash surrender value of a life insurance contraci 
Distribution rules .— Special rules apply under present law to pre 
vent the use of qualified pension plans, IRAs, and deferred annu 
ities for nonretirement purposes. Under these rules, any distribu 
tion from a qualified plan or IRA is treated as a pro rata recover 
of income and basis. Under a deferred annuity, distributions prio 
to the annuity starting date are treated as income first and then a 
a nontaxable recovery of basis. Partial surrenders and other with 
drawals under a life insurance contract are treated as basis firs 
and then income under present law. 

In addition, under qualified plans, IRAs, and deferred annuities 
an additional 10-percent income tax is imposed on income attribut 
able to distributions that occur prior to the attainment of age 59 V2 
death, disability, annuitization, and certain other events. This addi 
tional tax is intended to recapture partially the tax benefits of de 
ferral when tax-favored savings are not used for their intendec 
purposes. The 10-percent early withdrawal tax does not apply t( 
life insurance contracts under present law. 

Finally, under present law, an overall limit is imposed on th< 
amounts that can be distributed to a taxpayer during any taxable 
year from all qualified pension plans and IRAs. This overall limii 
IS enforced by an excise tax on any excess distributions. There is nc 
limitation on the annual amount that may be withdrawn from ? 
life insurance contract. 

Nondiscrimination rules.— The present-law rules for qualified 
pension plans allow the favorable tax treatment only if the plar 
complies with nondiscrimination rules that are intended to ensure 
that the plan does not disproportionately favor highly compensateq 
individuals. Similarly, the most favorable tax treatment of IRA^ 
(deductibility of contributions) is disallowed for married taxpayer 
with adjusted gross income above $50,000 (if either spouse is arj 
active participant in a qualified pension plan). On the other handj 
the favorable tax treatment of deferred annuities and whole life in] 
surance is not conditioned on the income level of the taxpayer. 

Loan restrictions.— In the case of most tax-favored forms of in 
vestment, present law provides restrictions on borrowing to pre 
vent current use of tax-deferred income. Thus, in the case of de 
ferred annuities, loans generally are treated as taxable distribu 
tions. In the case of qualified pension plans, loans in excess of thd 
lesser of $50,000 or 50 percent of the individual's accrued benefi! 
generally are treated as taxable distributions. No borrowing is per- 
mitted from an IRA. 

^ ^^.^h^.case of deferred annuities, loans generally are treated as 
taxable distributions of income first and then basis. By contrast, nd 
limitations currently apply to borrowing from a whole life insur] 
ance contract, other than restrictions on deductions for personal in] 
terest and for interest on loans by nonindividual holders of such 
contracts. 



13 

Limitations on tax benefits for corporate owners or benefici- 
ies. — Finally, the favorable tax treatment for IRAs, qualified 
ans, and deferred annuities is restricted to the situation in which 
I individual is the owner or ultimate beneficiary of the invest- 
9nt. In the case of whole life insurance, however, the favorable 
X treatment is also allowed for corporate owners or beneficiaries. 
Table 2 shows the comparative treatment of these various forms 
investment under present law. 



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16 

Tax treatment of insurance companies 

Under present law, a life insurance company generally is no 
subject to tax on the inside buildup on a life insurance or annuity 
contract because of the life insurance company reserve rules 
Under these rules, a life insurance company is allowed a deductioi 
for a net increase in life insurance reserves (taking into accoun 
both premiums and assumed interest credited to the reserves) an* 
must take into income any net decrease in reserves. The net in 
crease (or net decrease) in reserves is computed by comparing tb 
closing balance to the opening balance for reserves in the sami 
year. Life insurance reserves are defined to include amounts se 
aside to mature or liquidate future unaccrued claims arising fron 
life insurance, annuity, and noncancellable accident and health in 
surance contracts that involve life, accident, or health contingen 
cies at the time with respect to which the reserve is computed. 

The maximum reserve permitted under present law with respec 
to a contract equals the greater of (1) the net surrender value a 
the contract or (2) the Federally prescribed tax reserve. In comput 
ing the Federally prescribed reserve for any type of contract, th 
tax reserve method applicable to that contract must be used alonj 
with the prevailing National Association of Insurance Commission 
ers ("NAIC") standard tables for mortality or morbidity. The as 
sumed interest rate to be used to discount future obligations ii 
computing the Federally prescribed reserve generally equals th 
greater of (1) the prevailing State assumed interest rate (generallj 
the highest assumed interest rate permitted to be used in at leas 
26 States in computing life insurance reserves for insurance or ar 
nuity contracts of that type) or (2) the average applicable Federa 
rate (AFR) of interest (specifically, the average of the applicabl 
Federal mid-term rates for the most recent 60-month period begin 
ning after July 1986). 

Present law does not treat reserve deductions of insurance com 
panies as a specific item of tax preference under the corporate al 
ternative minimum tax. 



I II ANALYSIS OF TAX BENEFITS FROM INVESTMENT- 
ORIENTED LIFE INSURANCE PRODUCTS 

ish value insurance 

Under cash value (whole life) insurance, premiums in the initial 
sars after policy issuance exceed premiums for term insurance 
•oviding an equivalent death benefit. The excess premium is in- 
«ted and is credited, along with earnings, to the policyholder's 
sh surrender value. In the event of the policyholder's death, the 
ish surrender value is used to pay a portion of the death benefit, 
msequently, as the cash value grows over time, it pays an in- 
easing portion of the death benefit and reduces the mortality 
large on the contract. Thus, unlike term insurance, which has no 
vestment component, the premiums on a cash value contract do 
5t rise with the policyholder's age. In single premium life, the in- 
jstment component of the initial premium is so large that no ad- 
tional premiums need to be paid for insurance coverage. 
Table 3 compares term, ordinary (level premium), and single pre- 
lum life insurance for a $100,000 policy acquired by a 55 year old 
lale. Premiums and cash value are computed before loading 
larges using the 1980 Commissioner's Standard Ordinary ("CSO'O 
lortality table and a 6-percent interest rate. At age 55, the premi- 
m for term insurance is $988. By comparison, the premium for or- 
inary life insurance is $2,792, and for single premium life insur- 
nce is $33,034. The excess of these premiums over the cost of term 
isurance is invested and is credited, along with earnings, to the 
olicy's cash value. 

Table 3.— Term, Ordinary, and Single Premium Insurance ^ 

$100,000 death benefit, male age 55, 6-percent interest rate, net of loading charges] 

Term insurance Ordinary life Single premium 

Cumula- Cumula- Cumula- 

Age of tive Cash tive Cash tive Cash 

policyholder premium value premium va lue premium value 

,5 $988 $2,792 $1,933 $33,034 $34,328 

;0 .... 7,440 16,753 12,258 33,034 41,243 

15 17,473 30,715 23,494 33,034 48,767 

33,242 44,676 35,180 33,034 56,592 

'5''Z'Z''''. 58,334 58,637 46,671 33,034 64,288 

1 Assumes 100 percent of 1980 CSO mortality, 6-percent interest rate, ordinary 
ife paid up at age 100, premiums paid at beginning of year, and death benefits 
>aid at end of year. 

(17) 



18 

Preferential tax treatment of cash value life insurance 

The investment component of cash value life insurance receive] 
preferential tax treatment compared to other similar investmenij 
such as mutual funds, certificates of deposit, and savings account^ 
Income credited on such investments is included currently in thl 
investor's taxable income. By contrast, the investment income cred 
ited to a policyholder under a life insurance contract (referred to a 
"inside buildup") is not included currently in the policyholder') 
taxable income. Moreover, the inside buildup on the contract maj 
be withdrawn tax-free as a loan or partial surrender up to thi 
amount of premiums paid. Finally, benefits paid at death generally 
are excluded from income. Thus, unlike other investments, life in| 
surance policies allow deferral of tax on investment income, and i{ 
the policy is held to death, income tax may be avoided completely 

The preferential tax treatment of life insurance can be measure(! 
by comparing the policyholder's after-tax investment earning! 
under a contract to that of an individual who invests the casli 
value in a mutual fund with the same earnings rate. Table 4 com! 
pares, for a 55 year old male in the 28-percent tax bracket, th^ 
cash value that would accumulate by age 75 in a life insuranc^ 
policy as compared to a mutual fund, both yielding 6 percent pei 
annum before tax. ; 

For purposes of comparison, it is assumed that the amount in 
vested in the mutual fund is equal to the premiums paid on each oj 
4 different insurance policies: an ordinary life policy and three 
types of single premium policies. The first single premium policy 
the "standard" contract, is designed to have the lowest possible 
premium and thus the least inside buildup. The other two single 
premium policies shown in Table 4 are more investment orientedH 
they are designed to approximate the largest amount of inside 
buildup allowable under either the cash value accumulation test oH 
the guideline premium/cash value corridor test specified in Code 
section 7702. ^ In the most investment-oriented single premium poli^ 
cies currently being sold, stated charges for mortality and expenses 
are larger than the insurance company anticipates based on experi^ 
ence: this inflation of mortality and expense charges allows the in- 
surance company to offer more inside buildup than otherwise 
would be the case under the cash value accumulation and guideline 
premium tests. ^ To reflect the practices of some insurance compa- 
nies, the investment-oriented single premium contracts shown iri 
Table 4 are assumed to state mortality charges of 600 percent of 
1980 CSO. (For computing cash value, 100 percent of 1980 CSO is 
assumed.) 



2 Both policies have an initial death benefit of $100,000. To meet the cash value accumulation 
and guidelme premium tests, the death benefit is increased as necessary. 

^ It is questionable whether such a policy would qualify as life insurance under present law if 
mortality charges are not reasonably related to the risk being insured. 



19 

Table 4.— Comparison of Life Insurance and Mutual Fund 
Investments ^ 



-$100,000 initial death benefit, male 



age 55, 6-percent interest rate, net of loading 
charges] 



Single premium policy 



Item 



Ordinary 

•',^*= Standard 

Pol'«y policy 



Cash Guide- 

value line 

accum. premium 
policy 2 policy ^ 



remium or investment 

iisurance policy alterna- 
r tive: 

I Cash value age 75 

Tax on surrender 



3 $2,792 $33,034 $68,401 $62,570 

$46,671 $64,288 $209,301 $191,165 
$0 $8,751 $39,452 $36,007 



L After-tax value 

illutual fund alternative: ^ 
Cash value age 75 

|>fter-tax value of insur- 
ance as a percent of 
mutual fund investment ... 



$46,671 $55,537 $169,849 $155,159 
$96,463 $80,293 $166,258 $152,085 



48.4 



69.2 



102.2 



102.0 



- 1 For computing cash value, assumes 100 percent of 1980 CSO, 6-percent interest 
ate premTums plid at beginning of year, and death benefits paid at end of year^ 
'olicyholder is in 28-percent tax bracket and after-tax discount rate is 4.32 percent 
5 percent net of 28 percent tax). 

2 Contract states mortality charge of 600 percent of 19o0^|»": 

3 Annual premium; cumulative premiums to age 75 are $t)»,bd^ 

4 Insurance premiums invested in mutual fund earning 6 percent before tax (4.rfZ 
lercent after tax). 

Table 4 shows that the cash value in an ordinary life policy 
rrows to $46,671 at age 75 as compared to $96,463 if the premiums 
vere invested in a mutual fund. The cash value m a standard 
Jingle premium policy grows by age 75 to $64,288 before tax and 
655,537 after tax, as compared to $80,293 if the premiums were in- 
vested in a mutual fund. Thus, an investor would not purchase 
-ither of these insurance policies unless the investor wanted lite in- 
surance protection. By comparison. Table 4 shows that for the more 
investment-oriented single premium products, the atter-tax casn 
value at age 75 exceeds the value of investing the premiums in a 
mutual fund by approximately 2 percent. Thus, an individual 
would purchase an investment-oriented single premium lite insur- 
ance contract even if the individual was indifferent about purchas- 
ing life insurance protection because the value of investing in tne 
single premium policy exceeds the value of investing m a mutual 
fund even after mortality charges for insurance protection. 

Another way to analyze the preferential tax treatment ot lite in- 
surance is to compare a policyholder's tax liability under present 
law with what the tax liability would have been if inside buildup 
were subject to tax in the year earned. The difference in tax. liabil- 
ity is the benefit the policyholder obtains from the preferential tax 
treatment of life insurance. The tax benefit may be compared with 



20 

the value of life insurance coverage purchased. The value of life ir 
surance coverage is the cost of term insurance for the amount c 
the death benefit not paid for out of the policyholder's cash surrer 
der value. The value of tax benefits relative to the value of life ir 
surance coverage in a policy is a measure of the extent to whicl 
the tax system subsidizes the purchase of life insurance protectior 
Table 5 illustrates that the present value of tax benefits on a lif 
insurance policy increases the longer the contract is held becaus 
the tax on inside buildup is deferred for a longer period of tim€ 
For example, for a $100,000 ordinary life insurance policy acquirei 
by a 55-year old male, the present value of tax benefits increase 
from $556 if the policy is surrendered at age 60 to $4,395 if th 
policy is surrendered at age 75. If the policy is held until death 
which is presumed to occur at age 76 (the life expectancy of a 51 
year-old male), the value of tax benefits is $4,700. 

As a percent of the value of insurance coverage purchased, th( 
value of tax benefits on the ordinary life insurance contract in 
creases from 9.0 percent at age 60 to 17.7 percent at age 75, and is 
17 9 percent at death. Thus, in the typical ordinary life insurant 
policy purchased at age 55, the tax subsidy is a relatively smal 
portion (less than 20 percent) of the cost of the insurance coverage 
purchased. 

For the standard single premium policy, the value of tax benefits 
relative to the value of insurance coverage rises from 31.7 percent 
? Tu J®^^® *° ^^-^ percent after 20 years, and is 59.6 percent at 
death. For more investment-oriented single premium products, the 
value of tax benefits is a much higher percentage of the insurance 
coverage purchased. For the investment-oriented single premium 
policies shown in Table 5, the value of tax benefits is about 100 per- 
cent of the value of insurance coverage purchased after 15 yearsi 
and is over 300 percent of the value of insurance coverage at death! 



21 





















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This analysis illustrates that under present law it is possible t 
design single premium policies that provide tax benefits to the pol 
icyholder that are larger than the value of the insurance coveragi 
purchased. In these situations, single premium life insurance ma; 
be purchased exclusively as a tax-advantaged investment even i 
the policyholder does not need or want life insurance coverage 
Such a result is likely to occur if the insurance company takes ai 
aggressive position under which stated mortality and expens 
charges are higher than the life insurance company actual!; 
charges. 



' III. TAX POLICY ISSUES 

i A. Overview 

E 

n recent years, single premium life insurance and other forms of 

; insurance, such as universal life, variable life, and variable uni- 

rsal life, have been marketed as a tax-sheltered investment vehi- 

. For example, universal life insurance has been described as 

ving "earned its place in the list of portfolio alternatives. . . [as] 

Permanently tax-sheltered vehicle, offering attractive leverage at 

I ath with the essential risk element centered on fluctuating inter- 

! rates."* 

\nother article suggests that tax-shelter advisors: 

should sell single-premium policies by emphasizing the in- 
vestment side. The avoidance of current taxation makes 
SPLs [single premium life] more attractive than CDs or 
Treasuries. . .Today's SPL policies can provide minimum 
guaranteed returns roughly comparable to long-term mu- 
nicipal bonds or, for more aggressive clients, returns com- 
parable to mutual funds. . .Single premium variable life 
offers the growth potential of mutual funds, without cur- 
rent taxation. The best prospects for SPL products are 
high-bracket investors who want tax-advantaged, long- 
term savings with an insurance kicker.^ 

A third article indicates that investors and their advisors should 
c]eep in mind that this [single premium life insurance] is basical- 
an investment and secondarily a life insurance policy. If your 
lin concern is insurance coverage, then look to straight insur- 

ce."6 

Life insurance companies frequently market single premium life 
surance policies on the basis of favorable tax rules for loans. One 
tnpany states in its materials: 

The Story of SPL: Tax-Deferred Interest That Gives 
You Tax-Free Payments for Life 

Your first SPL premium will be your last. Immediately, 
it buys a lifetime of insurance with an initial face amount 
many times larger than your one and only premium. And 
immediately you'll start to get some tax benefits you may 
not even know existed. 



' Howard I. Saks, "Single Premium Universal Life Draws Attention as Interest Rates Plum- 

t," 12 Estate Planning 308, 310 (September 1985). See, also, "Firms Offering 'Universal Life' 

Benefit Plans," The Wall Street Journal, 31 (May 9, 1985). 

• Michael L. Markey, "Single-Premium Life is the Ideal Product for Clients Seeking. . .Invest- 

int — With a Life Insurance Kicker," The Stanger Register, July 1987. 

' Nancy Dunnan, "Insure a Tax Break in 1987," American Bar Association Journal, May 

^7. 

(23) 



24 

You see, life insurance is a uniquely tax-advantaged fi- 
nancial product. 

Your SPL begins immediately to earn tax-deferred inter- 
est at current, competitive rates. . . 

And, on the first anniversary of your owning an SPL, 
you may borrow your accumulated interest tax-free to use 
any way you choose. . . because the proceeds of life insur- 
ance policy loans are not subject to federal income tax. 

A Zero Interest Loan 

What's more, since . . . keeps paying you high, tax-de- 
ferred interest credits on the total amount of your bor- 
rowed values, your loan costs you nothing . . . 

There you have it: policy loans that put income tax-free 
money into your pocket and reduce the estate value of 
your life insurance only by the amount of the loans them- 
selves plus interest. 

The success of increased marketing of single premium life insuj 
ance is reflected by the sales growth of such policies. Table 6 coir 
pares the growth in single premium life insurance sales with th 
growth of other whole life insurance sales. The volume of singll 
premium life insurance sold has increased more than 800 perceh 
since 1984, while the volume of all other whole life insurance soli 
has increased only 22 percent. 

Table 6.— Annual Growth In Single Premium Life Insurance vt 
First Year Premiums For Whole Life Insurance (Excludiii 
Single Premium Life Insurance) ^ 

[Dollar amounts in billions] i 



Single premium Other whole life 



Year 



A . Percent » * Percent ! 
Amount ^^^^,^ Amount g^^^^^, 

1984 $1.0 $8.3 

1985 2.5 150 9.5 14 

1986 4.9 96 9.3 -2 

19872 9.5 94 10.1 9 

4 

* This table does not include the amount of policyholder dividends used duriri 

the year to purchase paid-up additions of life insurance coverage. 

^ Preliminary. i 

Source: Life Insurance Marketing and Research Association, Inc. [ 

The growth in the volume of single premium life insurance soli 
presents issues relating to the purpose for, and the effectiveness oi 
the favorable tax treatment provided life insurance products. A 
analysis of the principal tax policy issues follows. 



25 

B. Analysis of Specific Tax Policy Issues 
! [s the favorable tax treatment of life insurance justified? 

^ central issue in assessing the present-law tax treatment of life 
urance products is the appropriateness of excluding from income 
; inside buildup on life insurance policies. Even though a policy- 
Ider may have use of amounts earned inside a life insurance 
icy through loans or partial surrenders, the inside buildup gen- 
illy is not subject to tax. Further, the tax treatment of life insur- 
ce is inconsistent with the tax treatment of other investments, 
:h as bank certificates of deposit or mutual funds. The tax treat- 
snt of life insurance is also inconsistent (i.e., significantly more 
-^orable with respect to contribution limits, loans, and distribu- 
ns) with the treatment of tax-favored retirement investment 
-angements, such as IRAs, qualified pension plans (including 
ogh plans, qualified cash or deferred arrangements (401(k) 
ms)), and deferred annuities. 

The present-law tax treatment permitting deferral of tax (and, 
netimes, exemption from tax) of the inside buildup on life insur- 
ce contracts in effect allows taxpayers to purchase life insurance 
btection with the investment income on the contract that is not 
irrently subject to tax. This tax treatment operates as an incen- 
\e for taxpayers to provide adequate economic protection against 
-timely death. It may also operate as an incentive for saving. 
The incentive to protect against untimely death reflects a social 
licy goal, implemented indirectly through the tax law, to encour- 
e individuals to provide for their families' financial security out- 
le of formal Government programs such as social security and in 
'dition to the private pension system (for which tax incentives are 
50 provided). For example, a situation in which private pension or 
tirement-related benefits would not provide financial security 
iild occur when a wage-earner dies suddenly before retirement 
e and the principal short-term source of funds for the dependents 
the wage-earner is the proceeds of a life insurance policy. 
Various types of life insurance policies can provide the same 
ath benefit and, thus, the same protection for dependents, with 
ffering levels of tax benefits due to the different rates at which 
x-free inside buildup accumulates under each type of policy (see 
ible 5 above). Present law provides a larger tax incentive with re- 
ect to single premium life insurance as compared to ordinary life 
surance, and no incentive vsdth respect to term insurance. 
If, as a social policy goal, it is determined that investment 
come should not be taxed to the extent used to purchase insur- 
ice protection, then it may be argued that other forms of invest- 
ent income should not be taxed to the extent used to purchase 
surance protection. Under this analysis, taxpayers should be pro- 
ded a tax benefit if other investment income, such as income on a 
vings account, is used to purchase term insurance protection. 
Iso, if individuals may purchase additional insurance protection 
ith the previously untaxed investment income of a whole life in- 
irance policy, then arguably taxpayers should be allowed to 
jduct all or a portion of the cost of term insurance. 
Under present law, the owner of a bank certificate of deposit is 
ibject to tax on the interest income credited annually to the cer- 



26 

tificate. The same tax treatment applies to certain other forms c 
investment, the income on which is reinvested (e.g., the purchase c 
additional shares in a mutual fund). In addition, interest on zeil 
coupon bonds (and other types of original issue discount obliga 
tions) accrues for tax purposes as it is earned, even though it is no 
actually credited to an account for the owner. Taxing the insicJ 
buildup of life insurance policies would make life insurance equivg 
lent for tax purposes to other investments and would reduce a coni 
petitive advantage provided to life insurance companies thg 
market life insurance as an investment, rather than as economi 
protection in the event of death. 

On the other hand, some may argue that analogizing life insuj 
ance to certificates of deposit or mutual funds fails to recognize th 
character and importance of permanent life insurance. There ar 
two components to this argument. First, it is argued that the pui 
chase of whole life insurance is similar to the purchase of a hom 
or other capital asset. The appreciation in value of the home o 
other asset is not taxed until the asset is sold. 

This rationale may apply in situations in which the policyholde 
cannot borrow or otherwise use the earnings on the policy (by as 
signing or pledging the policy, for example), but is more tenuous t 
the usual case in which the cash value of the policy can be boi 
rowed. Life insurance products (other than pure term insurance 
have a significant savings component that is comparable in man 
respects to other financial products. Other financial products ger 
erally do not receive the same tax-favored treatment (i.e., exclusio 
or at least deferral of tax on earnings for both the owner of th 
asset and the financial intermediary providing it) that life insui 
ance products receive under present law. Thus, to the extent of th 
similarity in structure and use between life insurance products an 
other financial products, an argument can be made that it is unfai 
to exclude inside buildup while taxing income on comparable pro( 
ucts, and the rationable for the exclusion for inside buildup i 
weakened. 

Second, it is argued that only whole life insurance can provid 
long-term, systematic savings that ensure adequate death benefi 
protection. Term insurance cannot provide equivalent long-term s( 
curity for the average taxpayer because the term cost of insuranc 
becomes prohibitively expensive for older policyholders. Only a pei 
manent program of insurance, it is argued, can build sufficien 
cash value in the early years after policy issuance to cover th 
term cost of insurance protection in later years. 

2. Is the investment orientation of life insurance limited sufiR 
ciently by the deHnition of life insurance adopted in the Defi 
cit Reduction Act of 1984 (DEFRA)? 

The definition of life insurance added by DEFRA was intended t 
reduce the investment orientation of whole life insurance policies 
In the years before DEFRA, companies began emphasizing invest 
ment-oriented products that maximized tax deferral. When con; 
pared to traditional life insurance products, these policies offerej 
greater initial investments or higher investment returns. In r^ 
sponse, DEFRA provided a definition of life insurance that treated 
as currently taxable investments those life insurance policies thsj 



27 

e)vide for much larger investments or buildups of cash value than 
^ditional insurance products. 

however, the definition of life insurance adopted in DEFRA does 
^ limit permissible policies to those that provide a premium pay- 
,jnt pattern consistent with traditional forms of life insurance, 
]:h as a level premium pattern that continues until the maturity 
^e of the contract. DEFRA allows tax deferred growth for single 
pmium policies as long as the investment component of the 
j|.icy does not exceed certain parameters set forth in the defini- 
n. For the more investment-oriented single premium policies on 
^ market currently, present law provides a tax subsidy that is 
jTe than 300 percent of the value of the life insurance coverage 
.rchased (see Table 5 above). 

j\ basic issue is whether this level of tax-favored investment is 
^tified. The present-law definition of life insurance encourages 
irchase of single premium life insurance policies by higher 
;ome taxpayers with sufficient disposable income to afford such 
l).gle premium contracts. Such a definition provides a greater tax 
tiefit to high income taxpayers and, as such, creates inequities 
thin the Federal income tax system. 

f'urther, it can be argued that the definition of life insurance 
puld be tightened in order to ensure that life insurance is pur- 
^ased for death benefit protection and not as an alternative to 
liable forms of investment. Such a tightening of the definition of 
3 insurance would reduce the competitive advantage accorded to 
3 insurance companies over other financial intermediaries under 
3sent law and would limit the marketing of life insurance as a 
,t-favored form of investment. 

Life insurance companies point out that purchases of single pre- 
um life insurance are not limited exclusively to high income tax- 
yers and that companies permit the purchase of single premium 
licies with relatively low levels of initial investment. Taxpayers 
ay have other available assets, such as lump-sum distributions 
)m qualified pension plans, that they wish to use for investment 
life insurance. 

It may be appropriate to review the mechanics of the present-law 
finition of life insurance for possible abuses even if the funda- 
antal basis for the DEFRA definition of life insurance is deter- 
ined to be sound. For example, it may be appropriate to provide 
at the mortality charges that can be used in calculating whether 
contract satisfies the definition of life insurance must be based on 
e mortality charges used in determining the statutory reserve for 
e contract. 

Similarly, it may be appropriate to conform the determination of 
policyholder's basis for calculating gain in a policy to the deter- 
ination of basis for calculating loss. 

A corollary issue raised by the existence of a life insurance defi- 
tion that is intended to curb the investment use of life insurance 
the availability of other tax-favored products not limited by the 
sfinition. For example, it can be argued that if the definition of 
ie insurance is tightened to limit investment uses of insurance, in- 
sstors will purchase deferred annuities to obtain tax-deferred 
side buildup. Deferred annuities are not subject to contribution 
nits or to nondiscrimination rules as are other retirement vehi- 



28 

cles; nor are they specifically required to be used as an investmen 
to finance retirement, although present-law distribution rules foi 
such annuities are intended to discourage the use of such annuitie 
for nonretirement purposes. 

Thus, it can be argued that further restrictions on the amount c 
investment orientation permissible under life insurance contract 
will be ineffective unless corresponding changes are made in thj 
availability of deferral of tax through a deferred annuity contract 

An argument may be made, however, that the tax treatment (| 
inside buildup under deferred annuity contracts should not affec 
decisions to alter the definition of life insurance because deferrej 
annuity contracts are subject to less favorable tax treatment upoi 
partial surrender or withdrawal under present law. It could bi 
argued, therefore, that the restrictions on withdrawals from di 
ferred annuities would serve as a deterrent to investment in sue] 
annuities even if the definition of life insurance is modified tj 
reduce the permitted investment orientation. 

3. Is access to funds and noninsurance use of inside buildup coil 
sistent with the favorable tax treatment provided undcj 
present law? 

It can be argued that whole life insurance and similar product 
with cash value (and hence an inside buildup component) do nc; 
achieve their intended purposes under present law because th 
amount of the cash value can be borrowed or otherwise withdraw^ 
for other purposes during the insured person's lifetime, and is cor 
sequently not available to be paid as a death benefit. Thus, on 
could argue that the favorable tax treatment accorded to the insid 
buildup of a life insurance policy is justified only if the policy i 
used for its intended, tax-favored purpose and is not justified if th 
policyholder uses inside buildup directly (through partial surrer 
ders) or indirectly (through loans) for other purposes, such as shor^ 
term investment. Under present law, policyholders receive the bet 
efit of tax deferred inside buildup even though the amount se 
aside to fund a death benefit is reduced through loans or partly 
surrenders. | 

On the other hand, restrictions on the use of, or accessibility U 
the inside buildup of a life insurance policy may deter investmen 
in such policies and, therefore, may reduce the effectiveness of t' 
tax incentives created to promote the social policy of providing 
dependents financially after death. i 

An argument could be made that withdrawals from life insui 
ance policies should be permitted for other socially meritorious ei 
penditures (e.g., tuition costs) on a tax-free or at least tax-deferrej 
basis. For example, although the exclusion for inside buildup maj 
not initially have been intended to be used as a tax-free financinj 
vehicle for college tuition and other educational expenses, its usi 
as such is not inconsistent with the social policy to encourage ed 
cation and, thus, such a use of life insurance should continue to ' 
permitted. 

This reasoning could nevertheless be criticized because collegj 
tuition is generally not a deductible or otherwise tax-favored et 
penditure \yhen paid directly, and to treat it more favorably whe 
funded indirectly through life insurance merely encourages con 



i 



29 

»;x transactions, raises form over substance, and primarily bene- 
'3 the well-advised with capital to set aside. Further, the exclu- 
jn for inside buildup is not targeted to such purposes under 
3sent law, and this use of life insurance was perhaps not an in- 
faded consequence of the exclusion. 

^Should the treatment of contributions, distributions, and loans 
!with respect to life insurance be more consistent with the treat- 
jment of tax-favored retirement arrangements? 

|*resent law provides deferral of taxation on investment income 
''rned under certain types of retirement arrangements such as 
As, qualified pension plans, and deferred annuities (see Table 2 
ove). These arrangements, however, are subject to numerous re- 
actions generally designed to ensure that the tax benefit of defer- 
;i is targeted to the intended purpose, i.e., to create an incentive 
• saving for post-retirement periods when wage-earners' income 
rmally decreases significantly. Among the restrictions imposed 
r such retirement arrangements are: (1) restrictions on the 
iiiount that can be contributed to fund tax-deferred earnings; (2) 
ohibition or current taxation of loans; and (3) current taxation of 
({-deferred earnings that are distributed (including additional 
xes to take account of the deferral period in the case of early dis- 
butions). 

Contributions, distributions, and loans with respect to life insur- 

^.ce products are not subject to these types of limitations under 

esent law. It can be argued, however, that to the extent that the 

irpose of permitting tax-free inside buildup is related or compara- 

"3 to the purpose for providing tax-deferred earnings for retire- 

> 9nt arrangements, similar restrictions ought to apply. 

[The purpose of encouraging people to provide death benefits for 

eir dependents would be better served if there were disincentives 

use the cash value of life insurance for other purposes. Thus, it 

uld be argued that withdrawals and loans— which have the effect 

. reducing the death benefit available to the beneficiary— should 

)t continue to receive tax-favored treatment, but should be sub- 

zt to current taxation for the same reason that withdrawals and 

ans from retirement plans and deferred annuities are taxed. 

[nder this theory, it can be argued that loans under life insurance 

)licies should be treated as distributions, and that distributions 

lould not be treated as made first from basis. 

A counterargument would be that the purpose to provide death 

mefits is not sufficiently similar to the purpose to encourage the 

.'ovision of retirement benefits, and that, therefore, the treatment 

'.' loans and distributions from retirement vehicles is not appropri- 

e in the case of life insurance. As a consequence, the present-law 

ix-favored treatment of earnings on life insurance contracts 

lould be continued even if the taxpayer has current use of the 

inds. 

Drawing a further analogy between life insurance and tax-fa- 
Dred retirement vehicles, it could be argued that limits should be 
laced on the amount that can be contributed to fund death bene- 
ts on a tax-favored basis, similar to the contribution limits under 
itirement vehicles. Such a restriction would inhibit the use of life 



30 

insurance principally as a savings mechanism for current expenc 
tures of the policyholder that may be unrelated to death benefit 
and would tend to target the earnings on the life insurance co: 
tract to pay death benefits. 

Applying contribution limits to life insurance contracts may 1 
criticized on the grounds that it unreasonably limits the amount 
the death benefit that individuals may wish to provide for their d 
pendents. 

It can also be argued that comparable contribution limits shoul 
be applied to deferred annuity contracts. Otherwise, without par^ 
lei tax treatment, investors who now purchase investment-orient^ 
life insurance products would purchase deferred annuities in ord 
to obtain tax deferral for the maximum amount of investmei 
income. 

5. Is the present-law tax treatment of life insurance compani 
appropriate? 

Several arguments support the present-law tax treatment 
inside buildup on life insurance policies at the company lev( 
First, it can be argued that it is appropriate to allow reserve dedu 
tions for increases in cash value representing inside buildup on li 
insurance policies because the cash value approximates the valij 
of the company's current obligation to policyholders. Because it 
company includes the premium in income as it is received, ev^ 
though the benefit is to be paid far in the future (as actuarially d 
termined), income and deductions are better matched in time, froi 
a cash flow perspective, if the company can amortize its deducti< 
for the future benefit payment. ' 

This accounting treatment for future liabilities differs froi 
normal accrual method accounting for tax purposes. Thus, it can 1 
argued that it is not appropriate to permit life insurance comp 
nies, but not other taxpayers, a deduction for a future liability thj 
has not yet accrued (under the standard "all events" test) and wii 
respect to which there has not been economic performance (with 
the meaning of section 461(h)). 

This argument acquires additional force in light of the exclusi( 
for the inside buildup at the policyholder level. The overall resi 
is that in many cases the inside buildup on the policy is nev 
taxed to the policyholder or the beneficiary, or the life insuran 
company. Such a result may exceed the tax benefit necessary to ej 
courage the provision of death benefits for dependents. | 

Nevertheless, the fact that inside buildup is not subject to c\i 
rent taxation at the company level is supported by the argume: 
that the earnings do not really belong to the company. Under th 
argument, the company, as any other financial intermediary, 
mei;ely holding and accumulating the funds on behalf of the poliq 
holder and the beneficiary. Thus, it is appropriate that the compj 
ny not be taxed on income that ultimately belongs to someone els 

This argument ignores the fact that, in many cases, the insi< 
buildup is never taxed to anyone. Thus, it could be argued thj 
taxing the inside buildup at the company level would serve as 
proxy for taxing the inside buildup at the policyholder or benefi( 
ary level. ' 



IV. PROPOSALS TO RESTRICT THE USE OF LIFE 
INSURANCE AS AN INVESTMENT VEHICLE 

A. Policyholder Proposals 

f 1. Treatment of inside buildup under life insurance contracts 

ipose current taxation of inside buildup on all newly issued life 
\ insurance and deferred annuity contracts 

[As set forth in the President's 1985 tax reform proposals,^ the 
side buildup on all newly issued life insurance contracts and de- 
rred annuity contracts could be currently taxed to the owner of 
te contract. Under this proposal, the owner of the contract would 
elude in income for any taxable year any increase during the 
^ar in the amount by which the contract's cash surrender value 
ceeds the owner's investment in the contract. Special rules could 
provided for variable contracts in order to prevent taxation of 
e unrealized appreciation of assets underlying the variable con- 
acts. 

ipose current taxation of inside buildup on newly issued life insur- 
ance contracts held by nonnatural persons 

The inclusion in income of the inside buildup on newly issued 
e insurance policies could apply only to policies held by persons 
her than natural persons. This proposal would conform the treat- 
ent of the inside buildup on life insurance policies held by non- 
itural persons with the treatment of the inside buildup on de- 
rred annuity contracts held by such persons. 

Imit amount of inside buildup that is not subject to current tax- 
ation 

As an alternative to imposing current taxation on the entire 
nount of inside buildup, a limitation could be imposed on the 
nount of inside buildup for any taxable year that is not subject to 
IX. This limitation could be established at a level that would allow 

policyholder to avoid current tax on the amount of inside buildup 
lat would be credited on an ordinary life policy with the same 
3ath benefit or a policy with the same death benefit that provides 
»r level premiums over a specified period, such as 5 or 10 years. 

nder this alternative, the annual increases in the inside buildup 
1 deferred annuity contracts could be currently includible in 
icome. 

A similar result could be achieved by imposing a limitation on 
le annual amount or aggregate lifetime amount that a policyhold- 
r could invest in life insurance contracts and annuity contracts on 



» The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity (May 
>85), pp. 254-258. 

(31) 



32 

a tax-favored basis. Under this proposal, the inside buildup oi 
amounts invested in excess of the limitation would be subject t 
current tax. 

Treat inside buildup as an item of preference under minimum ta 

A more limited approach to imposing current taxation on insi(i 
buildup would be to treat all or a portion of the investment incomj 
on newly issued life insurance and deferred annuity contracts as i 
preference item for purposes of the alternative minimum tai 
rather than merely for purposes of the corporate book income prei 
erence or the corporate adjusted current earnings preferenc« 
Under this approach, a tax at the rate of 21 percent (20 percent i| 
the case of corporations) would be imposed on a taxpayer subject tj 
the minimum tax on the inside buildup on life insurance contract 
that are identified as excessively investment-oriented or on insid 
buildup in excess of a permitted amount or rate. 

2. Definition of life insurance i 

In general \ 

The statutory definition of life insurance could be narrowed fq 
newly issued life insurance policies to provide that significantly ii| 
vestment-oriented life insurance policies, such as single premium 
policies, would not be treated as life insurance for Federal inconi 
tax purposes. If a contract does not satisfy the statutory definitio 
of life insurance, then the inside buildup under the contract f(i 
any taxable year would be treated as ordinary income received i 
accrued by the policyholder during the year. In addition, amounij 
received upon the death of the insured would be excluded from th 
income of the recipient only to the extent that the amount receive 
exceeds the net surrender value of the contract. i, 

Require increased insurance protection during 5- or 10-year peril 
after issuance of contract 

The statutory definition of life insurance could be modified to r 
quire increased insurance protection during the first 5 or 10 yea: 
after the issuance of the contract. One method of accomplishir 
this result is to limit the amount of premium payments durir 
each of the first 5 (or 10) years after the issuance of the contract 
an amount that equals one-fifth (or one-tenth) of the maximu 
single premium that is allowed under present law for the year t 
contract is issued. 

Thus, under the cash value accumulation test, a contract wou 
not be treated as a life insurance contract for Federal income t^ 
pui^poses if the amount of the premium paid for any of the first 
(or 10) years of the contract exceeded one-fifth (or one-tenth) of tlji 
net single premium for the benefits provided in the contract. Sinji 
larly, under the guideline premium requirements, a contract wou 
not be treated as a life insurance contract for Federal income t 
purposes if the amount of the premium paid for any of the first 
(or 10) years of the contract exceeded one-fifth (or one-tenth) of i\ 
guideline single premium for the contract. 

Under this premium limitation requirement, a reduction in t| 
benefits under the contract during the first 5 (or 10) years after i\ 



33 

uance of the contract would require a recomputation of the 

igle premium for each year preceding the reduction in benefits. 

addition, rules may be necessary to address increased premium 
i.yments, reduced future benefits, and other similar modifications 

the contract that occur after the end of the 5-year (or 10-year) 
|,riod. 

^eatment of mortality charges and expense charges 

A further modification to the definition of life insurance would 

to determine the net single premium, guideline single premium, 

d guideline level premiums on the basis of the mortality charges 

tually charged to the policyholder or the mortality charges used 

determining the statutory reserve for the contract rather than 

e mortality charges specified in the contract. It is understood 

at some insurance companies specify excessive mortality charges 

a contract without actually charging the policyholder for such 

lounts in order to increase artificially the amount of the net 

igle premium, guideline single premium, or guideline level pre- 

iums for the contract. This results in an increase in the allowable 

sh surrender value under the cash value accumulation test or an 

urease in the amount of premiums that may be paid under the 

ideline premium requirements. 

In addition, restrictions could be imposed on the amount of ex- 
nses that are taken into account in applying the guideline premi- 
n requirements.^ For example, expenses could be limited to 10 
rcent of the mortality charges actually charged to the policyhold- 
; or used in determining the statutory reserve for the contract. 
The use of actual mortality charges (or the mortality charges 
ed in determining the statutory reserve for a contract) and the 
strictions on expense charges could apply for purposes of deter- 
ining the limitation on premiums payments during the first 5 (or 
i) years of the contract and/or for purposes of applying the cash 
ilue accumulation test and the guideline premium require- 
ents.^° In either case, rules may be necessary to address inflated 
ortality or expense charges that are refunded to policyholders. 

.terest rates used in determining net single premium and guideline 
premiums 

In determining the net single premium for purposes of the cash 
due accumulation test and the guideline premiums for purposes 
the guideline premium requirement, the interest rate could be 
ijusted to equal the greater of (1) the applicable Federal rate 
AFR") in effect on the date that the contract is issued, or (2) the 
ite guaranteed on issuance of the contract. The AFR is currently 
5ed to calculate life insurance reserves, as well as for other inter- 
it imputation purposes. 

' The expenses of issuing and maintaining a life insurance contract are not taken into ac- 
int in determining the net single premium of the contract, and, consequently, such expenses 
not affect the allowable cash surrender value under the cash value accumulation test. 
'° If the mortality charges used in determining the statutory reserve for a contract and the 
litation on expense charges are required to be used for purposes of applying the cash value 
cumulation test and the guideline premium requirements, the premium that could be charged 
• any life insuremce contract would be statutorily capped. 



34 

Treatment of variable contracts 

Any contract that provides a return that is based on the current 
investment return or current market value of a segregated assetj 
account (i.e., a variable contract) could be excluded from the defini 
tion of life insurance. Alternatively, variable life insurance con^ 
tracts could be excluded from the definition of life insurance if the 
policyholder is permitted to elect different investment options afteii 
the issuance of the contract. 

GA proposal relating to the treatment of loans in defining life iru, 
surance 

In a recent report on the taxation of single premium life insur^ 
ance, the General Accounting Office (GAO) suggested a change tc 
the statutory definition of life insurance. "^^ GAO proposed that 
the cash value corridor be modified for single premium contracts 
by reducing the amount of the death benefit by the amount of any 
loan outstanding under the contract. Because the minimum death 
benefit under a life insurance contract must exceed a specified per^ 
centage of the C£ish surrender value under the contract in order te 
satisfy the cash value corridor, the GAO proposal generally should 
limit the ability of policyholders to borrow against single premiuiB 
contracts. ^ ^ 

3. Treatment of pre-death distributions from life insurance 

contracts 

Description of H.R. 3441 

H.R. 3441 (introduced by Messrs. Stark and Gradison on October 
7, 1987) would alter the Federal income tax treatment of loans anc 
other pre-death distributions from life insurance contracts to con; 
form the treatment of distributions from life insurance contracts tC 
the treatment of distributions from annuity contracts prior to the 
annuity starting date. Under the bill, distributions from life insuri 
ance contracts would be treated as income first and then as recovi 
ery of basis. ^ ^ In addition, loans under life insurance contracts (inj 
eluding pledges and assignments of contracts) would be treated a^ 
distributions that are subject to the new basis ordering rule.^^ Fi' 
nally, an additional 10-percent income tax would be imposed on th^ 
portion of any distribution or loan under a life insurance contraq, 
that is includible in income. This early withdrawal tax would noj, 



" United States General Accounting Office, Briefing Report to the Honorable Fortney ^ 
(Pete) Stark, House of Representatives: Tax Policy, Taxation of Single Premium Life Insurant^ 
(GAO/GGD-88-9BR), October 1987. As an alternative to the change to the statutory definition d 
life insurance, GAO suggested that loans under single premium contracts be treated as distribU: 
tions. This alternative is summarized below in "3. Treatment of pre^eath distributions from li^' 
insurance contracts." 

'2 The principal reason for this result is that the GAO proposal does not reduce the cash su 
render value under the contract by the amount of the loan. Under present law, neither the cas 
surrender value nor the death benefit is reduced by policyholder loans in determining whether 
contract falls within the cash value corridor. 

' 3 Policyholder dividends under newly issued life insurance contracts generally would be sul 
ject to the new basis recovery rule. An exception to the new rule would be provided for policj 
holder dividends that are retained by the insurance company as a premium or other considei 
ation paid for the contract. This exception is consistent with the present-law treatment of policj 
holder dividends under annuity contracts. 

>•» H.R. 3441 also provides that a transfer of an insurjmce contract for less than full valu) 
would be taxable under the same rule that currently applies to annuity contracts. 



35 

>ily if a distribution occurs ( 1 ) after the holder of the contract at- 
*is age 59-1/2; (2) on account of the holder's disability; or (3) as 
-t of an annuity-type distribution over the holder's life expectan- 

LR. 3441 would apply to loans and other pre-death distributions 
t occur after October 7, 1987 (the date of introduction of the 
), but only to the extent that the amount distributed is allocable 
iaremiums paid on or after such date. 

lit application of H.R. 3441 to specific contracts 

'he provisions of H.R. 3441 could be limited to a specific class of 
itracts that are considered to be heavily investment-oriented. 
• example, the reversal of the basis ordering rule, the treatment 
oans as distributions, and the imposition of the early withdraw- 
:ax could be limited to contracts under which the amount of pre- 
''ims paid during any of the first 5 (or 10) years after the issu- 
:e of the contract exceed one-fifth (or one-tenth) of the maximum 
gle premium allowed under present law. Alternatively, the 
icter distributional rules could apply to a specific class of invest- 
nt-oriented contracts for a limited period of time after the issu- 
;e of any such contract. 

proposal relating to the treatment of loans as distributions 

n its recent report on the taxation of single premium life insur- 
;e,^^ GAO suggested that policyholder loans be treated in the 
ne manner as distributions under annuity contracts. Thus, the 
:ount of a policyholder loan would be includible in gross income 
the extent that the cash surrender value of the contract immedi- 
ly before the loan exceeds the investment in the contract at 
;h time. It is unclear whether the GAO alternative would change 
! basis ordering rule for other pre-death distributions from life 
urance contracts. ^ ^ 

her possible proposals relating to loans and partial surrenders 

Phe treatment of policyholder loans and partial surrenders 
der H.R. 3441 would be consistent with the treatment of loans 
i partial surrenders under annuity contracts. As an alternative, 
ns and partial surrenders under life insurance contracts could 
treated in the same manner as loans and early distributions 
m qualified pension, profit-sharing, or stock bonus plans. 
Jnder present law, a loan from a qualified pension, profit-shar- 
j, or stock bonus plan generally is treated as a taxable distribu- 
n from the plan to the extent that (1) the loan exceeds a speci- 
d amount (the lesser of $50,000 or one-half of the participant's 
:rued benefit) or (2) the time for repayment exceeds 5 years. In 
i case of a pre-annuity starting date distribution from a qualified 
nsion, profit-sharing, or stock bonus plan, part of the distribution 
[lonsidered basis recovery and the remainder is income. 

• See note 11, supra. 

' The GAO proposal indicates that if policyholder loans are treated in the same manner as 
ributions under annuity contracts, loans or distributions from income would be treated as 
ible income in the year withdrawn. 



36 

Policyholder loans could alternatively be treated as below-marke 
loans that are subject to the rules of section 7872. Under this pre 
posal, the policyholder would be treated as (1) paying a market rat 
of interest on the loan to the insurance company, and (2) receivin; 
a dividend from the insurance company equal to the amount c 
deemed interest.^' 

Finally, additional restrictions could be imposed on the dedud 
ibility of interest on indebtedness that is incurred with respect t 
life insurance policies. For example, interest on indebtedness tha 
is incurred with respect to life insurance contracts could be treat© 
as nondeductible (as is the case for interest on indebtedness that i 
incurred or continued to purchase or carry tax-exempt obligations] 
Under this approach, borrowing against the cash value of a policj 
a pledge or assignment of the policy, and borrowings to acquire q 
maintain the policy would result in nondeductible interest. ■ 

Alternatively, the present-law limit on the deductibility of intej 
est in the case of indebtedness exceeding $50,000 per officer or enl 
ployee of, or person financially interested in, any trade or busine^ 
carried on by the taxpayer could be decreased or an overall cap (ij 
addition to the present limit) could be placed on the amount of d^ 
ductible interest or allowable indebtedness. j 

Reduction of investment in contract by cost of term insurance 

As proposed by the President in his tax reform proposals « 
1985,^® a policyholder's basis (or investment in a contract) could ^ 
reduced by the aggregate cost of renewable term insurance provii 
ed under the contract. Consequently, under this proposal, policv 
holders would be unable to obtain the equivalent of a deduction fc' 
the cost of current insurance protection, which is generally regarf 
ed as a personal expense. ^ ^ 

4. Combination of definitional and distributional approaches 

A combination of the definitional and distributional approach 
could also be applied. Under this alternative, contracts that ai 
considered abusive would not qualify as life insurance, and, thu 
the inside buildup would be taxed currently to the policyholde 
Contracts that are not considered abusive but are considered exce 
sively investment oriented would be subject to stricter distributio 
al rules, such as basis reordering, the treatment of loans as dist 
butions, and the 10-percent additional income tax. All other cc 
tracts would continue to be governed by present law. 

B. Insurance Company Proposals 

"^he use of life insurance as an investment vehicle could also 
curtailed by changing the tax treatment of life insurance com 



' ' Absent a change in the basis ordering rule, this alternative would have minimal effef 
the use of policyholder loans because the deemed policyholder dividend would not be inclu' 
in income by the policyholder unless the dividend exceeded the policyholder's investment ii 
contract. 

' ^ The President s Tax Proposals to the Congress for Fairness. Growth, and Simplicitv (May 
pp. 254-258. 

" In determining the amount of any loss from the complete surrender of a life insur 
contract, the cost of insurance protection is not included in basis. London Shoe Co.. Inc., 80 
230 (2nd Cir. 1935); Century Wood Preserving Co., 69 F.2d 967 (3rd Cir. 1934). 



37 

!S. Under present law, the amount of the reserve for any life in- 
•ance contract may not be less than the amount credited to the 
;h value of the contract. Because a life insurance company is al- 
^ed a deduction for increases in reserves, the life insurance com- 
ly is not subject to tax on the inside buildup that is credited to 
J policy. 

mtment of reserves 

)ne method of addressing this issue at the life insurance compa- 
level (as opposed to the policyholder level) would be to deny the 
urance company a reserve deduction for all newly issued life in- 
-ance contracts. Under this proposal, an insurance company 
uld be allowed a deduction for death benefits only as the bene- 
3 are actually paid. Thus, the investment income on life insur- 
ze contracts would be subject to current tax at the life insurance 
npany level. 

Similarly, a portion of the inside buildup on investment-oriented 
itracts could be taxed to the insurance company by limiting the 
;erve for any contract to the amount of the reserve that would be 
owed for a contract with the same death benefit if the contract 
s funded on a level basis over a specified period, such as 5 or 10 
ars. Similarly, the provision of a loan could be taxed to the insur- 
ce company by requiring the insurance company to reduce its re- 
've for any contract by the amount of any loan outstanding 
der the contract. 

Alternatively, life insurance companies could be treated in the 
ne manner as other financial intermediaries (such as banks) 
th respect to deposits. Under this alternative, the receipt of pre- 
um income that is credited to the cash surrender value of a con- 
ict would be excluded from the gross income of the life insurance 
tnpany and only the excess of the death benefit over the cash 
rrender value would be allowed as a deduction to the life insur- 
ce company when the death benefit is paid. 

ternative minimum tax treatment 

Another approach would be to disallow deductions for life insur- 
ce reserves in computing the corporate minimum tax. Under this 
proach, reserve deductions for newly issued policies would not be 
rmitted in calculating an insurance company's alternative mini- 
im taxable income, with the result that the inside buildup on 
ose policies issued by an insurance company subject to the mini- 
im tax would be subject to tax at the corporate alternative mini- 
im tax rate of 20 percent. 

finitional approach to life insurance reserves 

The present-law definition of life insurance (or a modified ver- 
>n of it) could be applied at the insurance company level. That is, 
reserve would be permitted with respect to a contract that fails 
meet the definition of life insurance. 



V. ANALYSIS OF PROPOSALS TO RESTRICT THE USE d 
LIFE INSURANCE AS AN INVESTMENT VEHICLE 

Taxation of inside buildup 

The proposal to tax the inside buildup on all newly issued 
insurance contracts is considered by many to be an overly hi 
approach to limiting the use of life insurance as an investment} 
hide. Under such an approach, the inside buildup on ordinary 
insurance and other extended premium payment policies woulii! 
subject to current tax, although historically these policies have 
been purchased for the purpose of sheltering investment earnij 
It is argued that the taxation of the inside buildup on all life ini 
ance contracts would significantly reduce the amount of life i 
ance that is purchased and, thus, many dependents would be 
with an inadequate source of income upon the death of the insu 

On the other hand, it may be considered appropriate to tax 
inside buildup if the insurance is not purchased for the purpo^ 
providing for death benefits for dependents, regardless of the j' 
of premium payments under the contract. For example, many ! 
porations and other businesses purchase life insurance on the l' 
of employees solely as a tax-free or tax-deferred investment to j^ 
liabilities under nonqualified deferred compensation plans or o< 
similar liabilities. The ability of taxpayers to use life insuranc 
fund liabilities arising under nonqualified deferred compense 
plans creates a disincentive to establish qualified plans, wl 
must cover rank-and-file employees in addition to officers 
other highly-compensated employees in order to satisfy nondisci 
ination requirements. 

Others would counter that providing death benefits for dep 
ents is not the sole justification for favorable tax treatment of 
insurance contracts and that corporations and other busine 
have legitimate, nontax reasons for insuring the lives of key 
ployees of the business. It may be argued that purchases of lifd 
surance should be encouraged to preserve the stability of busin 
es (particularly small businesses). Further, banks and other firl 
cial institutions will often require the purchase of key empldi 
life insurance as collateral before lending to a corporation or oj 
business. 

If it is determined that the purchase of whole life insur^ 
sjiould be encouraged by providing favorable treatment of 
ii\side buildup but that such treatment should not be available 
higher-income taxpayers who use life insurance as a tax-shelt^! 
investment, it may be appropriate to impose an annual or lifet 
cap on the amount that may be invested in life insurance and 
ferred annuity contracts on a tax-favored basis. Alternatively, 
eluding the inside buildup on life insurance as an item of tax n 
erence for purposes of the alternative minimum tax also would 

(38) 



39 

ct the ability of higher-income taxpayers to shelter investment 
nings without adversely affecting other taxpayers. 

'inition of life insurance 

'he principal argument in support of proposals to modify the 
sent-law definition of life insurance to require increased insur- 
:e protection during the initial years of a life insurance contract 
hat such proposals affect life insurance contracts that are con- 
3red to be overly investment-oriented, rather all life insurance 
tracts. In addition, a modification to the definition of life insur- 
:e that reduces the amount of the premium that is available for 
estment purposes is likely to discourage the sale of life insur- 
!;e as a tax-sheltered investment rather than as a means to pro- 
e death benefits. 

)n the other hand, the definitional approach may be more com- 
X than the other alternatives and may be susceptible to manipu- 
on. For example, the present-law cash value accumulation test 
i the guideline premium requirements have been manipulated 
certain aggressive life insurance companies through the use of 
lated mortality and expense charges that are never actually 
irged to the policyholder. 

\ further element of complexity in a definitional approach that 
hibits the purchase of single premium life insurance is present- 
by various features of life insurance that might be characterized 
single premium life insurance. For example, an exchange of one 
'■ insurance contract for another could be viewed as a purchase 
single premium life insurance. In addition, purchases of paid-up 
iitions with policyholder dividends is, in essence, the purchase of 
iitional insurance coverage with a single premium payment. 
Cven if it is determined that increased insurance protection need 
; be required during the initial years of an insurance contract, it 
y be appropriate to clarify the present-law definition of life in- 
'ance to address inflated mortality and expense charges, 
iowever, a practical problem is presented by a proposal to ad- 
!ss the issue of overstated mortality and expense charges. Fre- 
3ntly, a life insurance company will reserve the right to reduce 
rtality or other stated charges if the company's experience is 
re favorable than was assumed. A proposal to require the use of 
ual mortality and expense charges would eliminate the flexibil- 
of companies to retrospectively readjust their stated charges. In 
iition, such a proposal might create additional complexity by re- 
aring annual retesting of all life insurance contracts in which the 
ted charges have not been applied. An alternative that may 
)ve more administrable might be to permit readjustments within 
(ermissible range of the mortality and expense charges stated in 
ontract. 

^'urther, care would be required to prevent the definitional limits 
life insurance from operating as price restraints. For example, 
J actual expenses associated with certain types of life insurance 
itracts may differ greatly from the expenses associated with 
ler types of whole life insurance. A definitional rule that limits 
J expense charges may operate to create price restraints for poli- 
s that actually generate greater expense charges than the limit. 



40 

Treatment of pre-death distributions 

Proposals for the reversal of the basis ordering rules, the tre{ 
ment of loans as distributions, or the imposition of a 10-perc 
early withdrawal tax for certain pre-death distributions under 
insurance contracts may be subject to criticism for inadequate 
targeting policies that are overly investment oriented. It is c 
tended by some that present law should continue to apply with 
spect to insurance contracts that provide a significant amount: 
insurance protection. Based on this argument, only those contra, 
that are defined as overly investment oriented would be subject! 
the stricter distribution rules. i 

Other opponents contend that the distributional approach wo< 
not curtail the sale of single premium and other heavily inv^ 
ment-oriented life insurance contracts because there is a sign 
cant tax advantage in the compounding of investment earnings 
a tax-free basis that would not be recaptured if the distribute 
occurs a significant period of time after the issuance of the c< 
tract. Instead, it is believed that the focus should be on the amoi 
of money that may be allocated to the cash value of a life in^ 
ance contract in relation to the amount of insurance protect] 
provided under the contract. j 

Those opposing changes to the treatment of loans under life \ 
surance contracts argue that policyholder loans should not 
treated differently from other loans secured by property that 
appreciated in value. For example, a taxpayer is not treated as 
alizing gain on a house that has appreciated in value if the taxp 
er borrows money using the equity in the house as collateral 
the loan. 

The principal argument in favor of the distributional approach 
that it would prevent policyholders from gaining ready access 
tax-free investment income and, thus, should ensure that life ins 
ance contracts are being purchased to provide death benefits for 
pendents rather than for other financial purposes. In addition, 
distributional approach generally is consistent with the present-] 
treatment of distributions from qualified pension plans and an 
ity contracts. If the distribution rules applicable to life insura] 
remain more favorable than the rules applicable to qualified p 
sion plans, employers will continue to have an incentive to est 
lish nonqualified deferred compensation plans that cover o 
highly compensated employees. 

An additional argument in favor of treating loans as distrij 
tions is that in most instances the policyholder is not obligated 
repay the amount borrowed. Ordinarily, the loan is satisfied by 
ducing the amount payable upon surrender of the contract or 
reducing the benefit payable to beneficiaries upon death. 

Treatment of life insurance companies 

It can be argued that the taxation of life insurance companies 
the inside buildup on life insurance contracts is likely to be m 
administrable than taxing the policyholders directly. In additi 
such an approach ensures that the inside buildup does not c^ 
pletely escape income taxation, which ordinarily occurs if a life 
surance policy is held until the death of the insured. 



41 

>n the other hand, the taxation of Hfe insurance companies on 
de buildup is inconsistent with the Federal income tax treat- 
it of other financial intermediaries, such as banks, mutual 
ds, and real estate investment trusts. Under present law, finan- 
intermediaries generally are not required to include in taxable 
)me the amount of investment earnings that are credited or oth- 
ise set apart for their customers. These investment earnings, 
/ever, generally are taxable to the customers of the financial in- 
nediaries for the taxable year in which credited or otherwise set 
rt. 

I O